Middle Market M&A -- Is Your Private Equity Buyer About To Become An Endangered Species?

Recently, University of Oxford professor Tim Jenkinson asked whether private equity as an investment asset class was “maturing.” He is director of the University’s Private Equity Program (Programme for those using the Queen’s English). Professor Jenkinson is also the co-author of a broad multi-year study of private equity; he and his co-authors have been the recipients of a few prestigious awards for the study.

Professor Jenkinson’s study has found that up until just a few years ago, average private equity fund multi-year performance outpaced that of the S&P 500 (or an international benchmark, as appropriate) by a meaningful amount. However, during the past few years, this performance has been roughly in line with the S&P 500. Which begged the question about whether the asset class was “maturing.”

Whether we are talking about privately held companies globally or just in the United States, the population of such firms is fairly well known. In the U.S., the market groups privately held companies by annual revenues.

Those private businesses with annual revenues above $500 million – so-called “pseudo-public” companies – number only a few thousand. Upper middle market companies – with annual revenues between $100 million and $500 million – account for roughly 25,000. Lower middle market firms – with annual revenues between $5 million and $100 million – total about 350,000. Finally, “micro” businesses are those will annual revenues below $5 million and number in the millions. Private equity funds and institutional buyers typically target only the first three groups.

Merger and acquisition professionals typically practice within one of these four revenue categories. Parallel to Professor Jenkinson’s findings, M&A professionals in the upper middle market and lower middle market have observed a terrain shift among private equity institutional buyers. As the large pseudo-public firms have been “picked through,” to find fresh investment opportunities, institutional buyers have turned to the upper middle market. But, those businesses – being limited in number – have also been picked through. With substantial cash still to be deployed, institutional buyers have taken an additional step into the lower middle market. This is what M&A professionals are seeing.

All of this gives one the sense of things being a seller’s market. And, for the past few years, it has been.

Now, the timing of this is curious. I say curious because studies of middle market M&A activity show a 10-year cycle. For five years, it will be a seller’s market. Then, for five years, it will be a buyer’s market. As it turns out, 2017 represents the fifth year in the current seller’s market. Of course, one could say that this cycle – which has been the pattern for about 30 years – is simply coincidental. Might there be an external factor that triggers a shift?

Over the past few weeks, two competing major tax reform proposals are on the table. Yes, there is other legislation that includes tax tweaks. But, the two proposals to which I am referring are comprehensive. And, advanced tax planners recognize that the two plans are leveling the playing field and a move towards a flat-tax system. Click here to see our article that discusses the tax reform proposals.

To make these flat-tax systems work, you need to move up the income statement. You need to move from “net income” to “EBITDA.” And, for the purpose of this discussion, the key point is “before interest.” Business entities will no longer be able to deduct interest expense. Oooh!

One will be quick to point out that private companies are typically valued as a multiple of EBITDA, thus, independent of the financing decision. Then, why should it matter? Recall that different types of buyers – strategic, financial, etc. – will pay different multiple ranges. And, also recall that your firm’s readiness for market determines which types of buyers might be in your specific pool of potential buyers. (A non-profit organization called the Middle Market Owners Forum is conducting a study of company readiness for sale. Click here to participate.)

But, given your firm’s readiness for sale, if the highest multiple buyer is a financial buyer – a PE fund – you have a problem. If you’re a private equity buyer, one deal structure that you’re going to use is the LBO (leveraged buy-out) model. Typically, the deal will be 10% - 15% cash equity from the buyer, 10% - 15% note carried back by the seller, and 75% bank loan financing. Of course, one needs a cash flowing company to support the interest payments on 85% - 90% of the deal.

Under the proposed tax reform proposals, the PE fund itself will be taxed (no more pass-through) and interest will not be deductible. This throws out of whack the entire economics of the LBO model that your PE buyer is going to use. Something has got to give. To sustain your 4X to 6X multiple, the PE fund’s expected rate of return must decline. Or, to sustain the PE fund’s expected rate of return, your valuation multiple must decline.

Now, recall the aforementioned “coincidental” seller’s market cycle that would seem to end in 2017. The proposed tax reform bills might be the external factor that triggers lower multiples. In the end, we’ll have to wait and see what comes to pass. But, if your sale timeline doesn’t extend out to the next seller’s cycle (say, 2022 to 2027), you might think about selling sooner rather than later.

I help business owners gain control over their firm's finances, enhance their firm's cash flow, and reduce the tax on the sale of their firm. See the Two-Minute Exit Coach at www.IntegratedWealth.com